California Scheming

E-retailers pick their poison: Give up many affiliates or charge sales tax to a quarter of U.S. shoppers

Things have been looking up for web-only retailer Blinds.com, where sales this year are on track to run 25% ahead of last year's $65 million—and that's following 2010 growth of more than 30% over 2009. "Most of the growth is due to conversion rate increases," says chief marketing officer Daniel Cotlar. He says visitors are buying more often because of improvements to Blinds.com, such as interactive videos that help shoppers choose window treatments.

But now the Houston-based retailer faces a dilemma that could pull the shades down on that innovative work and the growth it drives, Cotlar says. Seven states—Arkansas, California, Connecticut, Illinois, New York, North Carolina and Rhode Island—have passed laws in recent years requiring online retailers to collect sales tax if they get customers through web site affiliates based in those states.

Those seven states' populations total 86.6 million, more than 28% of the U.S. population of 308.7 million according to the 2010 census. These laws pose a stark decision for online retailers. Choice one is to stop working with online affiliates in those states and forfeit the traffic that comes from those sites, often information sites and blogs. Choice two is to charge sales tax to all residents of those states, and risk losing sales to consumers put off by the higher total ticket prices.

Retailers are crunching the numbers to see which of these unpleasant options will be the least damaging, and they're not all coming up with the same result. In part that's because severing ties with affiliates in California means more than losing referrals from in-state affiliates—it also may mean cutting ties with such important online marketplaces as eBay and Buy.com, which are based in California.

How tax impacts sales

More web retailers are likely to be making these calculations in coming months as seven more states are considering legislation that would require online sales tax collection from e-retailers that accept referrals from in-state affiliates. These laws are seeking a way around a 1992 U.S. Supreme Court ruling, which says that states can only force retailers to collect sales tax if they have an in-state physical presence, or "nexus" in legal terms.

Behind these laws are states' drive to find new revenue sources at a time when many face budget shortfalls. With online retailing growing steadily, it makes an attractive target. A study by the University of Tennessee estimates that the 45 states plus the District of Columbia that have state sales tax could gain over $20 billion in tax revenue by 2012 if all online retailers collected sales tax.

That means consumers paying $20 billion more for the goods they buy online—and many e-retailers figure consumers won't be happy to give up the pass they've gotten on sales tax at many e-commerce sites. Consumers are supposed to voluntarily pay their states the equivalent of sales tax on online purchases, but few do. That leaves retailers weighing how much they will lose in sales from affiliate referrals versus how many consumers will abandon purchases if they have to pay sales tax. There is evidence that charging tax cuts into online sales.

GSI Commerce Corp., a provider of e-commerce technology and services that was acquired by eBay Inc. in June, notes that sales at one of its client retailers dropped 12% over a nine-month period in 2008 and '09 in states where it had opened physical facilities and started collecting sales tax. And e-commerce technology and services company MarketLive Inc. found that a "sales tax-free holiday weekend" in South Carolina last month resulted in a 34% rise in sales at a client online retailer that normally collects sales tax in that state because it operates stores there.

Like some other e-retailers, including Amazon.com Inc. and Overstock.com Inc., Blinds has chosen to cut off affiliates rather than charge sales tax. It has already severed its relationships with affiliates in each state with an affiliate tax law, amounting to about 2,500 affiliates, or 25% of its total nationwide. "We know the drill," Cotlar says. "A state passes an affiliate tax law, we drop the state from our affiliate program."

What about eBay?

But some retailers are coming to a different conclusion. One sporting goods retailer, who asked to remain anonymous because it considers this a "politically and publicly sensitive matter," says it initially planned the same approach as Blinds throughout the U.S., but re-considered severing its affiliates in California after realizing that such a move would force it to cut its business ties with two big California-based e-marketplaces, eBay.com and Buy.com.

"At first we did the math if we collect sales tax in California, and the math indicated we'd be better off cutting off our affiliates," the retailer's manager of e-commerce says. "But after we started to read the California law, we concluded that any e-marketplaces based in California operating on a commission basis with other retailers could be subject to the nexus law." The California law applies to any retailer that does more than $500,000 in annual sales to California residents, including more than $10,000 through affiliate web sites. That means many eBay merchants, who are often smaller e-retailers, would not have to collect sales tax from California consumers; but this sporting goods retailer figures it's over the threshold.

So the retailer now has a multi-pronged tax collection policy: It has severed its affiliate relationships to avoid collecting tax in New York and the other states with affiliate tax laws, but it collects sales tax in two Midwestern states where it has physical operations as well as in California.

Blinds.com also did the math to determine whether it should collect tax in California, and stuck with its plan to cut affiliates. The choice wasn't easy.